Articlegreen2017

Are Stocks Riskier over the Long Run? Taking Cues from Economic Theory

Doron Avramov · Scott Cederburg · Katarína Lučivjanská

35 citations0/0 files storedReview of Financial Studies

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Financial Markets and Investment Strategies Stochastic processes and financial applications Financial Risk and Volatility Modeling

Abstract

We study whether stocks are riskier or safer in the long run from the perspective of Bayesian investors who employ the long-run risk, habit formation, or prospect theory models to form prior beliefs about return dynamics. Economic theory delivers important guidance for long-run investment opportunities. Specifically, incorporating prior information from the habit formation or prospect theory models reinforces beliefs in mean reversion and inferences that stocks are safer over longer horizons. Conversely, investors with long-run risk priors perceive weaker mean reversion and riskier equities. Model-based information is particularly important for inferences about uncertainty in the dividend growth component of returns. Received May 18, 2016; editorial decision April 25, 2017 by Editor Stijn Van Nieuwerburgh.

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1993Common risk factors in the returns on stocks and bonds 1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1965The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1971Optimum consumption and portfolio rules in a continuous-time model 1999By Force of Habit: A Consumption‐Based Explanation of Aggregate Stock Market Behavior 1989Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework

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